Transmission channels 57 (i) Long-term interest rate

The traditional macroeconomic view is that lowering the average maturity of government debt has the effect of reducing long-term interest rates facing pri-vate borrowers. This works through the portfolio rebalancing channel – which, as argued above, depends on the imperfect substitutability of assets of differ-ent maturity. It also depends on the willingness of banks to do interest rate arbitrage. Higher asset prices have wealth effects and, by making some finan-cial assets more reliable for posting as collateral, may ease borrowing con-straints. The policy entails monetary expansion. Again, these are very old questions. Several empirical studies conducted before 1960 formulated this issue in terms of the question: how much must the volume of money increase in order to reduce the bond yield by one percentage point? A J Brown’s an-swer in 1939, based on pre-war UK data, was 20%. A M Khusro’s anan-swer in 1952 was a range of between 10 and 30%. R Turvey’s 1960 study based on US data found that it took a 10% increase in money to lower the bond yield by one percentage point.⁵⁸

Lower long-term rates increases asset prices and aggregate demand (Tobin, 1963). But there has, over the years, been little consensus about the magnitude of these effects. Most early estimates of term structure equations, for instance, found it hard to detect any significant impact of changes in the relative

sup-57A reminder: this paper does not seek to address the implications for banks of central bank actions in short-term interbank markets.

58As reported in Dow (1965), pp 307, which contains the full references to the papers cited.

plies of short-term or long-term government bonds – perhaps because of too little variation in asset supplies.⁵⁹

Simulations with large scale econometric models, however, suggest that such effects could be of practical significance. One of the earliest studies is that of Ben Friedman (1992). He used a combination of the MPS (MIT-Penn-SSRC) quarterly econometric model of the US and a model representing the determi-nation of interest rates in four separate maturity submarkets for US govern-ment securities. He shows that:

“… a shift to short-term government debt lowers yields on long-term assets … and in the short run stimulates output and spending … the stimulus being con-centrated on fixed investment.”

The transmission mechanism (in his paper) worked through the corporate bond yield: lower bond yields stimulated business investment, reduced mortgage interest rates and the dividend-price yield. He found that a $1 billion per quar-ter shift from long-dated to short-dated debt would reduce the long-quar-term gov-ernment bond yield by 55 basis points. Note that this amounted to a reduction of one-fourth in the outstanding quantity of long-term Treasuries at that time – an operation that would today require many billions of purchases. This would increase real residential investment by almost 7% and investment in equip-ment by 2.5%: real GDP would rise by 1%. Corporate profits rise by 5%, and equity prices increase by 4%.⁶⁰ These results provide a quantification of Tobin’s earlier theoretical argument that shortening the duration of govern-ment debt would stimulate capital formation and growth.

59Some recent studies seem to find significant supply effects: see Krishnamvrthy and Vissing-Jorgensen (2010).

60See Table 13.1 of Friedman (1992). Note that the assumption about monetary policy in his simulation differs from recent studies of the impact of Quantitative Easing in the US and the UK: he assumes the growth rate of M1 is fixed so that the Treasury bill rate rises as short-dated paper replaces long-short-dated paper. The yield curve flattening is therefore larger. The Treasury bill rate rises by 67 basis points. Hence the yield curve flattens by more than a full percentage point.

(ii) Exchange rates⁶¹ Domestic

Large-scale

official purchases to lower long-term yields should shift portfolio demands from domestic to foreign assets. The resultant capital flows into higher-yielding foreign assets will tend to limit the decline in local yields. This should induce currency depreciation, which would reinforce the impact on aggregate demand noted in (i) above. In a small country with a tightly man-aged exchange rate link to a large country, long-term yields would change little. In the case of US policies aimed at lowering US yields, Neely (2010) finds evidence that, following US quantitative easing, yields on non-US bonds also fell by 45 basis points (compared with the estimated 90 basis points for US Treasuries) and the dollar depreciated by 5%. Hence a country acting alone gets some additional stimulus from currency depreciation. But if other coun-tries also adopt more expansionary policies – perhaps in order to limit cur-rency appreciation – it benefits from increased exports.

foreign

The governments of countries that share a common monetary area (eg the euro area) may take advantage of their independence in debt management policies to offset their lack of monetary policy independence. Hoogduin et al (2010) draw attention to a coordination problem that is specific to the euro area. They find evidence that a steep yield curve prompts debt managers in individual official purchases of US Treasuries also drive down long-term yields, reinforcing the impact of the Federal Reserve’s QE. But the im-pact on the exchange rate would have the opposite sign – at least to the extent that the alternative for foreign official purchasers would be increased pur-chases of non-US debt securities (eg bunds or gilts). The dollar would tend to appreciate as foreigners buy US bonds. Hence the combined impact of both foreign official and Federal Reserve purchases of US Treasuries on the ex-change of the dollar is of uncertain sign. Relative magnitudes may provide some guide. At end-2009, the Federal Reserve held under $800 billion of US Treasuries; the reported direct holdings of foreign official institutions were

$2.7 trillion.

61This section does not address the wider issue of the impact of fiscal deficits on the real ex-change rate. In the short run a fiscal deficit may lead to real appreciation but a rise in the debt-dependent risk premium suggests real depreciation in the long run. See Kugler (1998).

countries to shorten the maturity of their debts. A government in a small coun-try might not see this as increasing its own refinancing risks.⁶²But if several countries act in this way it does increase refinancing requirements for the euro area as a whole. This will serve to increase the speed of transmission of shocks in one country (Greece recently) to other countries seen as sharing similar ex-posures. They conclude on “the need for coordination … to limit the use of short-term debt”. This was not covered in the Maastricht Treaty.